Is Valuing a Young Start-Up More Art or Science?

Placing a dollar value on a private company – determining its “valuation,” in investment-industry parlance – isn’t easy, especially when the company is barely more than an idea in the minds of inexperienced entrepreneurs.

FirstMark Capital Managing Director Rick Heitzmann took a chance on a little-known company called Pinterest, which has since exploded in popularity among users.

So how do investors value fledgling start-up?

Many venture capitalists, such as Rick Heitzmann, will tell you “it’s more art than a science.” Mr. Heitzmann, managing director of New York-based early-stage technology investor FirstMark Capital, says factors include the track record of the founding team, the size of the market opportunity and whether the company’s product or service has already gained users or begun making revenue.

A start-up that is strong in one of the categories can secure a much larger valuation, even if it is deficient in the other two, he said. “If Jeff Bezos (the founder of Amazon.com Inc.) decides he’s leaving Amazon to start a new company, it wouldn’t matter if he had no idea what the company was going to be,” he said.

But more often than not, seed-stage investors have little to base their decisions on. With competition fierce for the hottest deals, they’re under pressure to accurately gauge a company’s worth in the early stages, or risk backing a dud.

A lot is on the line: Median valuations for seed financings in 2011 reached $2.9 million, more than 60% higher than the previous year and the highest total since the dot-com frenzy of 2001, according to industry tracker Dow Jones VentureSource, a unit of Wall Street Journal owner News Corp.

So seed investors often rely on a “spray-and-pray” approach to investing, sprinkling small amounts of money in a large share of start-ups hoping one or two will catch fire.

Catching fire is exactly what happened in the case of social media company Pinterest, which in three years has gone from an unknown start-up when FirstMark first invested to a popular high-flyer valued at $1.5 billion in its latest round.

“They were guys that had not had much experience,” Mr. Heitzmann said of Ben Silbermann and his co-founders, who started their company in 2008. “We thought they had great potential. But they had no traction, and an interesting but still undefined market. So we did the seed investment.”

Eighteen months later, the company had performed well, showing consistent growth each month, Mr. Heitzmann said. Bessemer Venture Partners, a large venture firm whose roots date back to the Carnegie family in the 19th century, came aboard as the lead investor in the Series A round.

A new round of valuation negotiations was necessary, since the company had made significant progress and a new investor was coming aboard. At that point, Pinterest was valued at $40 million, according to The Wall Street Journal.

A few months later, in October of 2011, the company raised its Series B round, this time with Menlo Park-based Andreessen Horowitz as the lead investor, at a valuation of a reported $200 million. Around that time, Pinterest was attracting about 5 million unique visitors, according to analytics firm Compete.

“We now knew the company could keep it up, the growth was scalable,” Mr. Heitzmann said, explaining the swift rise in valuation. “The guys had proven they were great entrepreneurs. And people loved the product.”

In May, Japanese e-commerce company Rakuten Inc. led a $100 million financing round for Pinterest that valued the company at $1.5 billion, The Wall Street Journal reported, even though the company still produces virtually no revenue. Companies that are worth more than $1 billion are excluded from consideration for The Wall Street Journal’s “Next Big Thing” list of the top 50 venture-backed start-ups in the U.S., since the aim of the list is to find up-and-coming start-ups that haven’t yet reached those lofty heights.

Mr. Heitzmann declined to say how much FirstMark Capital invested in the company or what its ownership percentage was, but he confirmed that it was a “typical” seed deal.

While venture capitalists see company valuations as discrete snapshots in time, tied to financing rounds and driven by gut-level decision-making, others see valuations as much more science than art.

Susan Woodward, founder of Palo Alto, Calif.-based Sand Hill Econometrics, uses data provided by VentureSource, to calculate valuations for about 8,000 companies every month, including those that make up the WSJ’s Next Big Thing list.

Roughly 40% of companies report their valuations to VentureSource, tied to their most recent funding rounds. For the 60% who don’t, Woodward’s firm uses complex algorithms to calculate it, running regression analyses and examining a series of factors including how much money the company raised in its most recent funding round, its total fundraising amount, the industry it’s in, whether it’s profitable, and how much revenue it produces, if any.

The formulas include a “decay function,” meaning valuation decreases the longer a company goes without raising new financing. They also take into account the fact that companies that don’t report their valuations tend to be less valuable than those that do.

Additionally, Woodward’s firm uses an accounting principle called “mark-to-market” – tying valuation to overall trends in the public stock markets, using the Dow Jones Total Stock Market Index. For example, a company valued at $40 million in 2005 would have been valued at $80 million in 2008, all other things being equal, since the overall value of the stock market roughly doubled between those two dates.

Woodward, a former chief economist for the U.S. Securities and Exchange Commission and the U.S. Department of Housing and Urban Development, sees her statistics-based valuation work as very different from that done by venture investors, who are making largely instinctive decisions based on pattern recognition and tried-and-true industry guidelines.

“It’s rule-of-thumb stuff,” she says. “VCs are sophisticated and they are doing it full time, but they make mistakes.”

But sometimes, the results are life-altering — possibly like Heitzmann’s investment in Pinterest, if everything goes right.

Comments (2 of 2)

Its heartening to see investors hitting it big on occasion. IMO, the "art" of valuing a startup is part intuition (this entrepreneur, this idea), part 'market' (supply/demand for this type of startup at present) and part options pricing (basically buying a call option hoping stock is worth 10x a few years forward) recognizing massive variance in possible outcomes.

8:40 am October 22, 2012

Daniel wrote:

Valuations are indeed important in determining the return on investment and at the same time in not breaking the thin line of agreement between founders and investors. I however do not agree about the rule of thumb or the "it's just an art" approach. Especially from the standpoint of the entrepreneur, who, confronted by VC, has no knowledge in how to defend a valuation. Here at Equidam we are fitting into this problem providing startup valuation reports for a low price that may not be exact but allow the negotiation to focus on specific assumptions instead of the feelings of the two parties.

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